Central Banks Helped Contribute To The Financial Crisis

Even before the crisis, there were some who stressed that
monetary policy should keep an eye on asset bubbles and the
growth of credit.

This column argues that the policy of inflation targeting,
used widely in the 1990s and 2000s, did indeed lead to excessive
credit growth that eventually bred financial instability.

As numerous studies over the last two decades have shown,
interest rate policies of a large number of central banks can be
explained by the so-called Taylor Rule.

According to this rule, which is consistent with inflation
targeting, the policy rate is determined by a neutral real rate,
the target inflation rate, the output gap, and the deviation of
inflation from the target (or expected) rate. In this formula,
the output gap can be interpreted as a leading indicator for
inflation, as suggested by an augmented Phillips-curve inflation
model, where the deviation of actual inflation from the target
has the character of an error-correction term.

There is no room for financial variables, such as money, credit,
or asset prices, in this policy rule.

Leading economists and central bankers have indeed suggested
that monetary policy should abstain from trying to prick asset
price bubbles, but stand ready to support banks and financial
markets when the bubbles burst (Bernanke and Gertler 2001).

Only a minority have seen this differently and argued that
monetary policy should lean against asset price inflation and
monitor credit developments closely to this effect (ECB 2005).

As technical progress and global trade integration depressed
prices in the 1990s and 2000s the Taylor Rule suggested that
policy rates be kept low over an extended period of time despite
strong credit growth and asset price increases. In this column we
show how the policy of inflation targeting, which essentially
implies that the central bank minimize the output gap, has led to
excessive credit growth that eventually bred financial
instability.

Credit and the output gap

We have argued at some length in the past that because credit
growth is a stock variable and domestic demand is a flow
variable, the conventional approach of comparing credit growth
with demand growth is flawed (see for example Biggs et al. 2010a,
2010b).

To see this, assume that all spending is credit financed. Then
total spending in a year would be equal to total new borrowing.
Debt in any year changes by the amount of new borrowing, which
means that spending is equal to the change in debt. And if
spending is equal to the change in debt, then the change in
spending is equal to the change in the change in debt (i.e. the
second derivative of the development of debt). Spending growth,
in other words, should be related not to credit growth, but
rather the change in credit growth.

We have called the change in debt (or the change in credit
growth) the 'credit impulse'. The credit impulse is effectively
the private sector equivalent of the fiscal impulse, and the
analogy might make the reasoning clearer. The measure of fiscal
policy used to estimate the impact on spending growth is not new
borrowing (the budget deficit), but rather the change in new
borrowing (the fiscal impulse). We argue that this is equally
true for private sector credit.

Our credit impulse approach has proved useful for the analysis
and forecasting of economic activity in both the US and the
Eurozone over the past three years. Domestic demand growth in the
US rebounded in line with the credit impulse in 2010 (Figure 1),
even though credit growth was still negative (Figure 2). The same
was true in the Eurozone and many other countries around the
world. With the concept of the credit impulse we could also
debunk the myth of creditless recoveries (or so-called 'Phoenix
Miracles') (Biggs et al. 2010a).

Monetary policy and financial instability

We argued in the previous section that GDP growth should be
related to the credit impulse, or the change in new borrowing.
Figure 1 above for the US provides a sense of the nature of the
relationship. When the credit impulse is zero, growth tends to be
close to potential. Fluctuations in the credit impulse around
zero cause fluctuations in GDP around trend.

If fluctuations in the credit impulse around zero are correlated
with fluctuations in GDP growth around trend, then it follows
that the output gap must be correlated with new borrowing as a %
of GDP (Biggs and Mayer 2012). This logical implication of the
credit impulse argument is supported by the empirical evidence.
Figure 3 shows the correlations between the output gap (as
estimated by the OECD) and private sector new borrowing as a % of
GDP in the US. The correlation is excellent.

Figure 3. US output gap and new borrowing

Source: OECD, US Federal Reserve,
Deutsche Bank Research

The implications of this view is that if we know what new
borrowing as a % of GDP is, we have a reasonable estimate of the
output gap. If new borrowing is high as a % of GDP then the
economy is operating above potential. For given periods of time,
credit growth can be used as proxy to new borrowing in % of
GDP1 and
hence provides a readily available, excellent indicator for a
possible overheating of an economy, which is much easier to
measure than the unobservable output gap. Figure 4 shows the two
variables for the US. Nominal credit growth is well correlated
with the output gap.

Figure 4. US output gap and credit growth

Source: OECD,US Federal Reserve,
Deutsche Bank Global Market Research

Figure 4 has interesting implications for the sustainability of
economic growth. In the US, over the past 20 years an output gap
of 0% has been consistent with nominal credit growth of 7.0%.
Potential nominal GDP growth averaged 4.8% in the US over the
observed period and less than 4.0% in the Eurozone. In other
words, when the output gap was 0%, credit was rising faster than
nominal GDP and the debt ratio was rising. Exactly the same was
true in the Eurozone.

An output gap of 0% would have suggested that the economy was
performing at its potential and on a growth path that is
generally perceived as being sustainable. Unless there were
worrisome signals from actual inflation, the Taylor Rule would
have suggested that policy interest rates were appropriate at
existing levels. However, the right hand scale of the Figure
suggests that growth at potential went along with credit growth
that was faster than nominal GDP growth. In other words, growth
in line with potential was associated with an ever increasing
debt-to-GDP ratio. What might have appeared to have been a
sustainable growth path from an output gap perspective was a
growth path that gave rise to unsustainable debt dynamics. In
short, the application of the Taylor Rule by the US Federal
Reserve would have paved the way towards excessive debt
accumulation, financial instability, and the subsequent financial
crisis.